Making The Figures Add Up

I got asked a question today about the sub prime motor and thought I would share it here.
The question was along the lines of "How can the finance company know who is going to pay and who isnt going to pay"

Well this is quite interesting because, we don't. What we do know, using our existing data is that if we lend to 100 customers aproximately 20 will not pay. So this raises an interesting question about pricing and rate for risk etc.

In the old days there would be a model for offering a "rate for risk" plan. Oh yes, the concept sounds good - get the people who are higher risk to pay more, however, it is totally flawed. This is because, you only make money if people pay you back (end of). If the higher risk customers dont pay, it makes no difference what "rate for risk" price you made. The other thing is that the customers more likely to pay will be less likely to take the higher rate, therefore making the overall "rate for risk" top heavy with desperate customers who have no intention to pay.

So, then how does it work in practice? Well, in essence its very straight forward. Remember the 80 will pay and the 20 will not?, well the 80 who pay, have to provide enough profit to make up the shortfall from the 20 that dont pay, hence the rates being higher in sub prime lending. Sure you will get some return on repossessions of vehicles of those 20 non payers, however, the cost of collecting on those accounts, sale costs and legal action etc. will swallow much of this up.

Therefore I would ask that for those righteous people who believe that these customers are getting "ripped off" think about it a little more. Heres an analogy, if your wanting to grow 100 tomato plants, you dont plant 100 seeds - you know that some wont make it, so you compensate for that.

i hope this makes things a little more easier to understand

Sub Prime credit crises in a nutshell

High-Risk Customer: Gee, I’d like to buy a house, but I haven’t saved any money for a down payment and I don’t think I can afford the monthly payments. Can you help me? Mortgage Broker: Sure! Since the value of your house will always go up, we don’t need down payments anymore!
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Mortgage Broker: And we can give you a really, really low interest rate for a few years. We’ll raise it later, okay?
High-Risk Customer: Sure. Ummm…there’s one other thing — my employer is a real prick and might not verify my employment. Would that be a problem?
Mortgage Broker: Nope — we can get you a special “Liar’s Loan” and you can verify your own employment and income!
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High-Risk Customer: You guys are awesome! You’re really willing to work with guys like me.
Mortgage Broker: Well, we don’t actually lend you the money. A bank will do that. So we don’t really care if you repay the loan. We still get our commission.
High-Risk Customer: Wow! Let’s get started!
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A Few Weeks Later, at the Bank…


Banker: I’d better get rid of these crappy mortgage loans. They’re starting to stink up my office. Thankfully, the really smart guys in New York will buy them and perform their financial magic! I’ll call them right away!
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Let’s See What the Smart Guys are Doing…


Investment Banker Boss: Phew! We’d better get rid of these shitty mortgages before they start attracting flies.
Investment Banker Underling: But who would buy this crap, boss?
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Investment Banker Boss: I’ve got it! First we’ll create a new security and use these crappy mortgages as collateral. We’ll call it a CDO (or maybe a CMO). We can sell that CDO to investors and promise to pay them back as soon as the mortgages are paid off.
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Investment Banker Underling: But crap is crap, isn’t it, boss? I don’t get it.
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Investment Banker Boss: Sure! Individually, these are pretty crappy loans, but if we pool them together, only some of them will go bad — certainly not all of them. And since housing prices always go up, we really have very little to worry about.
Investment Banker Underling: I still don’t get it.
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Investment Banker Boss: The new CDO will work like this: it’ll be made up of three slices or tranches and we’ll call them:
• The Good
• The Not-So-Good
• The Ugly
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Investment Banker Boss: If some of the mortgages fail, as surely some might, we’ll promise to pay investors holding the “Good” tranche first. We’ll pay the “Not-So-Good” investors second, and the “Ugly” investors last.
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Investment Banker Underling: I’m starting to get it. And because the “Good” investors have the least risk, we’ll pay them a lower interest rate than the other guys, right? The “Not-So-Goods” will get a better interest rate and the “Ugly” guys will get a nice fat interest rate.
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Investment Banker Boss: Exactly. But wait — it gets better. We’ll buy bond insurance for the “Good” tranche. If we do that, the rating agencies will give it a really good rating, in the AAA to A range. They’ll likely give the “Not-So-Good” tranche a BBB to B rating. We won’t even bother asking them to rate the “Ugly” tranche.
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Investment Banker Underling: So you’ve managed to create AAA and BBB securities out of a pile of stinky, risky mortgage loans. Boss, you’re a genius!
Investment Banker Boss: Yes, I know.
Investment Banker Underling: Okay, now who are we going to sell the three tranches to?
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Investment Banker Boss: The assholes at the SEC won’t let us sell this stuff to widows and orphans, so we’ll sell them to our sophisticated institutional clients.
Investment Banker Underling: Like who?
Investment Banker Boss: Like insurance companies, banks, small towns in Norway, school boards in Kansas — anyone looking for a high-quality, safe investment.
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Investment Banker Underling: But surely nobody would buy the “Ugly” tranche, would they?
Investment Banker Boss: Of course not — nobody’s that stupid! We’ll keep that piece and pay ourselves a handsome interest rate.
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Investment Banker Underling: This is all great, but since we’re only using the smelly mortgages as collateral on an entirely new security, we haven’t really gotten rid of them. Don’t we have to show them on our balance sheet?
Investment Banker Boss: No, of course not! The guys who write the accounting rules allow us to set up a shell company in the Cayman Islands to take ownership of the mortgages. The crap goes on their balance sheet, not ours. The fancy name for this is “Special Purpose Vehicle”, or SPV.
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Investment Banker Underling: That’s great, but why would they let us do that? Aren’t we just moving our own crap around?
Investment Banker Boss: Sure, but we’ve convinced them that it’s vitally important to the health of the U.S. financial system that investors not know about these complex transactions and what’s behind them.

A brief explanation why the vehicle value is important to subprime lending

Why is it that people who are classed as subprime struggle to get a personal loan, but can be approved for car finance by numerous companies, surely lending money is all the same?

The answer is quite straightforward, but maybe confusing to those who are not in the subprime finance business. In essence it boils down to a simple case of security and potential loss. If someone defaults on a personal loan, there is no real potential of recovery of any of the funds in a swift period of time.
For instance, customer A defaults on a personal loan, apart from taking them to court and trying to recover income from them, there is no alternative and if the customer has a genuine reason for default, it’s unlikely that you would obtain a judgement for anything meaningful in terms of monthly instalments. Therefore your loss is total – advance, minus payments made and the derisory judgement the court makes in a repayment schedule; assuming that the customer actually keeps to it. In this scenario, your return will drip feed in over many years and without doubt you will have to chase the customer for the payments as well. All in all, not a good position to be in if you’re a lender, this is why loans with no security are few and far between in the subprime world.

Let’s now take the subprime car loan. First of all, the lender knows that there is an asset they can repossess and sell in the event of default, so immediately were ahead of a personal loan in terms of loss. Secondly, we know that the vehicle is more than likely a critical requirement for the customer, few people want to get public transport and nowadays in general we all prefer to travel by car. This means that the customer has a reason to pay for the loan as well, so were looking good now.
Not only do we have some immediate return in the event of default, we also know there is a need for the customer to pay for the loan, rather than the basic obligation of a finance agreement.
So we now need to analyse what the loss situation is going to be. The loss is in direct proportion to the amount you lend on the vehicle relative to resale/auction value. Lending someone £10,000 on a car loan that’s worth £600 at an auction is dumb and is as good as writing a personal loan. Sure, cars still depreciate; however, you’re betting that the instalments made will help offset this problem.
A standard market value in the subprime sector is to lend retail value (mileage adjusted), using an agreed independent and updated valuation source (Glass Guide or CAP) in the hope you will obtain trade price at the auctions. For those not in the “know” circa 120-125% of trade represents the retail amount, however, prices do vary.
Operating in this manner, the dealership or seller makes enough profit out of the metal for it to be worth their while and the finance company “ideally” has an asset that can realise a good amount in the event of repossession and resale at auction. This will ensure that the loss isn’t total and those customers who pay will pay for those that don’t.
The only security superior to that of a vehicle, is obviously the security of a charge on the property.